May 1998

Understand Mutual Fund
Distributions and Minimize Taxes

© Talbot Stevens

The benefits of mutual funds, combined with baby boomers' need to save for their own retirement, have fueled tremendous growth in the mutual fund industry.

For all of their benefits however, simplicity is one of the things that GIC investors give up when they pursue the potentially higher returns of mutual funds. Understanding how mutual funds work can be very intimidating, especially for new investors.

Mutual funds are very similar to stocks where you buy shares of a company. When you buy a mutual fund, you own a certain number of units or shares, which fluctuate in value. The value of your investment is simply the number of shares owned multiplied by the current share price.

Like stocks that often pay dividends to shareholders, mutual funds generally pay distributions to their unit holders. Income funds typically pay distributions monthly or quarterly, while equity funds usually make distributions annually. Most equity investors automatically reinvest their distributions to purchase additional units.

Understanding, and keeping track of, distributions is important. Outside of an RRSP, these distributions are taxable, regardless of whether they are automatically reinvested.

When an equity fund produces a 10% total return, some of the gain is reflected in a higher share price, and some of the gain is reinvested distributions.

After a distribution, the price per unit drops by the value of the distribution, and additional units are issued to reflect the reinvested distributions. Thus, you own more units at a lower price, maintaining the same value before and after the distribution.

The increase in unit price of non-registered equity funds is a capital gain. This results in two tax benefits. Only 75% of the gain is taxable, and it is not taxed until you sell.

When you withdraw your funds, you pay tax on just the gain or increase in value. The total amount of your contributions to a fund, including reinvested distributions, is not taxable when withdrawn and is called the Adjusted Cost Base, or ACB.

Assume you invest $10,000 that grows, including $5,000 of distributions, to $30,000 and you cash in. The taxable gain is not $30,000, or even $20,000. The ACB is $10,000 plus $5,000 of distributions, or $15,000. Thus, the capital gain is only $15,000, not $20,000.

Without carefully tracking your distributions and ACB, you could end up paying more tax than needed.

It is also important to keep records of any sales commissions paid, as these are indirectly tax deductible. Transaction costs reduce your net taxable gain.

Clearly, it is important to understand and keep good mutual fund records. Otherwise, you will pay unnecessary tax, and no one likes to do that!

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